How businesses can lower their cost of debt and save money
Businesses rely on debt to expand, invest, and stay competitive. But borrowing money isn’t free—there’s always a cost attached. The cost of debt is the price companies pay for using borrowed funds, and if not managed properly, it can eat into profits and even lead to financial trouble. On the flip side, understanding and controlling this cost can help businesses maximize returns and make smarter financial decisions.
What is the cost of debt?
The cost of debt is the effective interest rate a company pays on its borrowings, including loans and bonds. It represents how much it costs a company to finance its operations using debt rather than equity. This number matters because it directly affects a company’s profitability and ability to make smart financial decisions.
A business typically funds its operations in two ways: through debt (borrowed money) or equity (selling shares to investors). Debt financing often comes with lower costs than equity financing since interest payments on debt are tax-deductible, making it a cheaper way to raise funds. However, carrying too much debt can be risky because it creates fixed financial obligations that must be paid, regardless of the company’s revenue.
Comparing cost of debt with cost of equity helps businesses determine the best mix of financing. While debt has a fixed repayment structure, equity involves giving up ownership and future profits. Striking the right balance between the two is key to maintaining a healthy capital structure—the mix of debt and equity a company uses to fund its activities.
Nominal vs. Effective cost of debt
The nominal cost of debt is the stated interest rate a company pays on its debt. If a company takes out a loan with a 6% interest rate, the nominal cost of that debt is 6%. It’s straightforward, but it doesn’t always give a full picture.
The effective cost of debt, on the other hand, accounts for additional factors like fees, compounding interest, and tax benefits. In reality, companies may pay more (or sometimes less) than the nominal rate due to these factors.
For example, a bond issued at a discount (sold for less than its face value) has a higher effective cost of debt because the company has to repay the full face value at maturity. Similarly, if interest compounds, the total cost can be higher than expected.
Tax benefits also play a big role. Since interest on debt is tax-deductible, the after-tax cost of debt is lower than the before-tax cost. A company in a high tax bracket benefits more from these deductions, effectively reducing the interest rate it pays.
For financial planning, the effective cost of debt is a better measure because it reflects the real cost of borrowing, not just the number on paper. Investors, creditors, and company executives rely on this number to assess financial health and make informed decisions.
How to calculate cost of debt
Understanding how to calculate the cost of debt is essential for businesses to manage their borrowing efficiently. It’s typically calculated in two ways: before-tax cost of debt and after-tax cost of debt.
Before-tax cost of debt
The before-tax cost of debt represents the total interest a company pays on its borrowings before considering tax benefits. It’s calculated using this formula:
Total interest expense divided by total amount borrowed.
For example, if a company has taken out multiple loans at different interest rates, the total interest expense across all loans is divided by the total amount borrowed to find the average cost of debt.
Let’s say a business has:
- A $500,000 loan at 5% interest
- A $1,000,000 loan at 7% interest
The total interest paid annually is $60,000 (5% of $500,000) plus $70,000 (7% of $1,000,000), totaling $130,000.
If the total outstanding debt is $1.5 million, then the before-tax cost of debt calculation is:
(130,000 / 1,500,000) = 0.0867 or 8.67%
So, the company’s before-tax cost of debt is 8.67%.
After-tax cost of debt
Since interest on debt is tax-deductible, companies actually pay less in real terms after accounting for tax benefits. The after-tax cost of debt is calculated using the formula:
Before-tax cost of debt x (1 – tax rate)
If the company in our example has a 30% tax rate, its after-tax cost of debt would be:
8.67% x (1 – 0.30) = 8.67% x 0.70 = 6.069%
This means that after taxes, the company effectively pays only 6.069% on its debt instead of 8.67%.
For businesses, this lower cost makes debt a more attractive option compared to equity financing, where dividends are not tax-deductible.
Alternative calculation using bond yield-to-maturity (YTM)
For companies that issue bonds, the cost of debt is often measured using the yield-to-maturity (YTM), which represents the total return an investor expects if they hold a bond until it matures.
YTM is a more accurate measure because it includes market fluctuations, interest payments, and the time value of money. It’s calculated based on the bond’s current market price, face value, coupon payments, and time to maturity.
Another important concept is the bond equivalent yield (BEY), which helps compare bond returns with other interest rates in the market. Investors and companies use BEY to ensure they are getting a fair return compared to alternative investments.
By using YTM, companies can estimate their true cost of issuing bonds and adjust their borrowing strategies accordingly.
The cost of debt for public vs. private companies
Public and private companies calculate their cost of debt differently because they have access to different types of financing.
Public companies often borrow money by issuing bonds in financial markets. Since their bonds are publicly traded, investors and analysts can use the yield-to-maturity (YTM) of those bonds to estimate the company’s cost of debt. Large companies also receive credit ratings from agencies like Moody’s or S&P, which help determine their borrowing rates.
Private companies, on the other hand, don’t issue public bonds and usually rely on bank loans or private debt agreements. Since there’s no market-based way to determine their borrowing cost, private companies must calculate it based on their loan agreements, interest rates, and financial statements.
A private company might estimate its cost of debt by looking at:
- The interest rates on its existing loans
- Market rates for similar businesses with comparable risk levels
- The rates banks or private lenders offer when refinancing debt
Public companies generally have more financing options, while private companies often pay slightly higher interest rates since their debt is considered riskier due to lack of transparency and public credit ratings.
Regardless of whether a company is public or private, accurately estimating the cost of debt is essential for financial planning, securing new loans, and making strategic decisions about capital structure.
The role of taxes in cost of debt
One of the biggest advantages of debt financing is that interest payments are tax-deductible, which reduces the real cost of borrowing. This is why companies often prefer debt over issuing stock—because it lowers their taxable income.
Let’s say a company has $1 million in debt with an interest rate of 6%, meaning it pays $60,000 in interest per year. If the company has a corporate tax rate of 30%, it can deduct the full $60,000 from its taxable income.
This tax benefit effectively reduces the company’s after-tax cost of debt, calculated as:
Interest rate x (1 – tax rate)
Using our example:
6% x (1 – 0.30) = 6% x 0.70 = 4.2%
Instead of paying 6% on its debt, the company effectively pays only 4.2% after taxes.
This tax advantage makes debt a cheaper financing option compared to equity, where dividends paid to shareholders are not tax-deductible. However, companies must be cautious—borrowing too much can lead to financial instability, especially if revenues decline and they struggle to meet interest payments.
Key factors that influence the cost of debt
The cost of debt isn’t fixed—it fluctuates based on a company’s financial situation and external economic conditions. Several factors play a role in determining how much a company pays to borrow money.
Interest rate environment
A company’s borrowing cost depends heavily on market interest rates, which are influenced by central bank policies, inflation, and overall economic conditions. When interest rates rise, borrowing becomes more expensive, increasing the cost of debt.
Credit rating and risk perception
Lenders determine interest rates based on how risky they think a company is. Companies with higher credit ratings (AAA, AA, A, etc.) receive lower interest rates, while those with lower ratings (BB, B, or worse) pay higher rates because they are seen as riskier borrowers.
If a company’s financial health declines—say, due to falling revenue or excessive debt—its creditworthiness suffers, increasing its cost of debt.
Type of debt instrument
Not all debt is the same. Bank loans, corporate bonds, and convertible debt each have different interest rates. Bonds with a fixed interest rate have a set cost, while variable-rate loans fluctuate with market conditions.
Company financial health
Companies with strong cash flow, profitability, and manageable debt levels qualify for better loan terms. A business with too much debt relative to its earnings will struggle to get favorable interest rates.
Understanding these factors allows companies to proactively lower their cost of debt by improving their financial standing, securing better loan terms, and timing their borrowing wisely.
Managing and reducing the cost of debt
Since debt is an ongoing financial commitment, businesses must actively manage their borrowing costs. Here’s how they can do that.
Improving creditworthiness
A company’s credit rating and financial health directly impact its cost of debt. Keeping a healthy debt-to-equity ratio, maintaining strong cash flow, and showing consistent profitability can help secure lower interest rates.
Refinancing debt
Refinancing means replacing an existing loan with a new one at a lower interest rate. If interest rates drop or the company’s financial health improves, refinancing can cut costs significantly.
However, refinancing isn’t always free—prepayment penalties and closing fees may apply. Companies must weigh the savings against any refinancing costs before making a decision.
Using tax strategies
Since interest expenses are tax-deductible, businesses should structure their debt to maximize tax benefits. Choosing the right mix of short-term and long-term debt, leveraging tax credits, and working with financial advisors can help optimize borrowing costs.
Diversifying debt sources
Instead of relying on a single lender, businesses can explore multiple financing options such as bank loans, corporate bonds, government grants, or alternative lenders. This gives them flexibility and negotiating power to secure the best rates.
Reducing the cost of debt requires smart financial management, strategic borrowing, and leveraging tax benefits. Companies that manage their debt effectively gain a competitive edge by keeping financing costs under control.
Example calculation of cost of debt
Let’s walk through a real-world example to see how cost of debt impacts financial decisions.
Company ABC has two loans:
- A $2 million loan at 6% interest
- A $3 million loan at 5% interest
The total interest expense per year is:
(2,000,000×0.06)+(3,000,000×0.05)=120,000+150,000=270,000
The total outstanding debt is $5 million, so the before-tax cost of debt is:
(270,000 / 5,000,000) = 0.054 or 5.4%
Now, let’s calculate the after-tax cost of debt assuming a 30% tax rate:
5.4%×(1−0.30)=5.4%×0.70=3.78%
This means after accounting for tax benefits, the company’s effective borrowing cost is 3.78% instead of 5.4%.
This calculation helps businesses decide whether borrowing is a good financial move and compare debt financing with other funding options.
Wrapping up
Understanding the cost of debt is crucial for businesses looking to optimize their financial strategies. Whether a company is public or private, managing borrowing costs effectively can increase profitability, lower risks, and create more growth opportunities.
By calculating both before-tax and after-tax cost of debt, businesses can evaluate the true impact of borrowing. Using smart strategies—like improving credit ratings, refinancing at better rates, and leveraging tax deductions—can help reduce financing costs.
Debt is a powerful tool, but only when managed wisely. Companies that keep their cost of debt in check are in a stronger position to grow, invest, and succeed in the long run.
FAQs
How does the cost of debt impact a company’s valuation?
The cost of debt affects a company’s weighted average cost of capital (WACC), which is used to determine its valuation. A lower cost of debt can increase a company’s market value by making capital more affordable. However, excessive debt can raise financial risk, leading to lower valuations.
Can a company have a negative cost of debt?
No, a company’s cost of debt cannot be negative. However, in rare cases, real interest rates (adjusted for inflation) can be negative if inflation is higher than the nominal interest rate. This means borrowing costs are effectively lower in real terms, but the stated cost of debt remains positive.
How does the cost of debt differ across industries?
Different industries have varying levels of financial risk and capital intensity, which affect borrowing costs. Capital-heavy industries like manufacturing or energy often rely more on debt and may have higher cost of debt. In contrast, stable industries like utilities often secure lower interest rates due to predictable cash flows.
What happens if a company underestimates its cost of debt?
If a company miscalculates its cost of debt, it may overestimate profitability and take on more debt than it can handle. This can lead to cash flow problems, difficulty in meeting interest payments, and even financial distress. Accurate calculations ensure sound decision-making.
How do interest rate hikes affect a company’s cost of debt?
When central banks raise interest rates, borrowing costs increase, making new loans and refinancing more expensive. Companies with floating-rate debt see immediate increases in payments, while those with fixed-rate debt feel the impact when refinancing or seeking new funding.
